Banking panics and policy responses

When policy makers have limited commitment power, self-fulfilling bank runs can arise as an equilibrium phenomenon. We study how such banking panics unfold in a version of the Diamond and Dybvig (1983) model. A run in this setting is necessarily partial, with only some depositors participating. In addition, a run naturally occurs in waves, with each wave of withdrawals prompting a further response from policy makers. In this way, the interplay between the actions of depositors and the responses of policy makers shapes the course of a crisis.     

Credit and identity theft

The quintessential crime of the information age is identity theft, the malicious use of personal identifying data. In this paper we model “identity” and its use in credit transactions. Various types of identity theft occur in equilibrium, including “new account fraud,” “existing account fraud,” and “friendly fraud.” The equilibrium incidence of identity theft represents a tradeoff between a desire to avoid costly or invasive monitoring of individuals on the one hand, and the need to control transactions fraud on the other. Our results suggest that technological advances will not eliminate this tradeoff.     

On the pricing of intermediated risks: Theory and application to catastrophe reinsurance

We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be “high” in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price.     

Information, heterogeneity and market incompleteness

Information is “market-consistent” if agents only use market prices to infer the underlying states of the economy. This paper applies this concept to a stochastic growth model with incomplete markets and heterogeneous agents. The economy with market-consistent information can never replicate the full information equilibrium, and there are substantial differences in impulse responses to aggregate productivity shocks. These results are robust to the introduction of a noisy public signal and aggregate financial markets. We argue that the principle of market-consistent information should be applied to any model with incomplete markets.     

Strategic Auditor Behavior and Going-Concern Decisions

This paper analyzes a game-theoretic model in which a client can potentially avoid a going-concern opinion and its self-fulfilling prophecy by switching auditors. Incumbent auditors are less willing to express a going-concern opinion the more credible the client's threat of dismissal and the stronger the self-fulfilling prophecy effect. Similarly, the client is more willing to switch auditors the more likely it is that auditors' reporting judgments will differ and the stronger the self-fulfilling prophecy effect. Further, with greater noise in the auditor's forecast of client viability, the auditor tends to express fewer going-concern opinions.     

Incentives to innovate and financial crises

In this paper I develop a model of a competitive financial system with unrestricted but costly entry and an endogenously determined number of competing financial institutions (“banks” for short). Banks can make standard loans on which plentiful historical data are available and unanimous agreement exists on default probabilities. Or banks can innovate and make new loans on which limited historical data are available, leading to possible disagreement over default probabilities. In equilibrium, banks make zero profits on standard loans and positive profits on innovative loans, which engenders innovation incentives for banks. But innovation brings with it the risk that investors could disagree with the bank that the loan is worthy of continued funding and hence could withdraw funding at an interim stage, precipitating a financial crisis. The degree of innovation in the financial system is determined by this trade-off. Welfare implications of financial innovation and mechanisms to reduce the probability of crises are discussed.     

On measuring synchronization of bulls and bears: The case of East Asia

This paper implements estimation and testing procedures for comovements of stock market “cycles” or “phases” in Asia. We extend the Harding and Pagan [Harding, D., Pagan, A.P., 2006. Synchronization of cycles. Journal of Econometrics 132 (1), 59–79] test for strong multivariate nonsynchronization (SMNS) between business cycles to a test that allows for an imperfect degree of multivariate synchronization between stock market cycles. Moreover, we propose a test for endogenously determining structural change in the bivariate and multivariate synchronization indices. Upon applying the technique to five Asian stock markets we find a significant increase in the cross country comovements of Asian bullish and bearish periods in 1997. A power study of the stability test suggests that the detected increase in comovement is more of a sudden nature (i.e. contagion or “Asian Flu”) instead of gradual (i.e. financial integration). It is furthermore argued that stock market cycles and their propensity toward (increased) synchronization contain useful information for both investors, policy makers and financial regulators.     

Information acquisition and financial contagion

This paper incorporates costly voluntary acquisition of information à la Nikitin and Smith (2007) [Nikitin, M., Smith, R.T., 2007. Information acquisition, coordination, and fundamentals in a financial crisis. Journal of Banking and Finance, in press, doi:10.1016/j.jbankfin.2007.04.031], in a framework similar to Allen and Gale (2000) [Allen, F., Gale, D., 2000. Financial contagion. Journal of Political Economy 108, 1–33], without relying on any unexpected shock to model contagion. In this framework, contagion and financial crises are the result of information gathering by depositors, weak fundamentals and an incomplete market structure of banks. It also shows how financial systems entering a recession can affect others with apparently stronger economic conditions (contagion). Finally, this is the first paper to investigate the effectiveness of the Contingent Credit Line procedures, introduced by the IMF at the end of the nineties, as a mechanism to prevent the propagation of crises.     

Capital market imperfections and the theory of optimum currency areas

This paper studies how within- and cross-country capital market imperfections affect the welfare effects of forming a currency union. The analysis considers a bank-only world where intermediaries compete in Cournot fashion and monitoring and state verification are costly. The first part determines the credit market equilibrium and the optimal number of banks, prior to joining the union. The second part discusses the benefits from joining a currency union. A competition effect is identified and related to the added monitoring costs that banks may incur when operating outside their home country, through an argument akin to the Brander-Krugman “reciprocal dumping” model of bilateral trade. However, in our framework, whether joining a union raises welfare of the home country is ambiguous; it depends on the relative strength of “investment creation” and “intermediation diversion” effects.     

Government Deposit Insurance and the Diamond-Dybvig Model

The apparent banking market failure modeled by Diamond and Dybvig [1983] rests on their inconsistently applying their sequential servicing constraint to private banks but not to their government deposit insurance agency. Without this inconsistency, banks can provide optimal risk-sharing without tax-based deposit insurance, even when the number of type 1 agents is stochastic, by employing a contingent bonus contract. The threat of disintermediation noted by Jacklin [1987] in the nonstochastic case is still present but can be blocked by contractual trading restrictions. This article complements Wallace [1988], who considers an alternative resolution of this inconsistency.     

Exchange rate regimes, banking and the non-tradable sector

This paper presents a small-open-economy, two-good version of the Diamond and Dybvig model with cash constraints to analyze the implications on banking of different exchange rate regimes and monetary policies. I show that fixed exchange rates with a Central Bank providing liquidity in local currency imply Pareto efficiency, with conditions for a run equilibrium stronger than in the literature. In a flexible exchange rate regime, multiple equilibria may not be eliminated. In particular, for very a expansive monetary policy there exists an equilibrium where a fraction of patient consumers purchases dollars in the interim period, which constitutes a partial currency run. A dollarized banking system without international short-run credit may also implement the efficient allocation under certain conditions.     

Safe but fragile: Information acquisition,liquidity support and redemption runs

This paper proposes a theory of redemption runs based on strategic information acquisition by fund managers. We argue that liquidity lines provided by third parties can be a source of financial fragility, as they incentivize fund managers to acquire private information about the value of their assets. This strategic information acquisition can lead to inefficient market liquidity dry-ups caused by self-fulfilling fears of adverse selection. By lowering asset prices, information acquisition also reduces the value of funds’ assets-under-management and may spur inefficient redemption runs by investors. Two different regimes can arise: one in which funds’ information acquisition incentives are unaffected by the volume of redemptions, and another where market and funding liquidity risk mutually reinforce each other.     

How to reduce unemployment: A new policy proposal

This paper uses a model with a continuum of equilibrium steady state unemployment rates to explore the effectiveness of fiscal policy. The existence of multiple steady state equilibria is explained by the presence of search and recruiting costs. I use the model to explain the current financial crisis as a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices. I ask two questions. (1) Can fiscal policy help us out of the crisis? (2) Is there an alternative to fiscal policy that is less costly and more effective? The answer to both questions is yes.     

Runs,panics and bubbles: Diamond–Dybvig and Morris–Shin reconsidered

The basic two-noncooperative-equilibrium-point model of Diamond and Dybvig is considered along with the work of Morris and Shin utilizing the possibility of outside noise to select a unique equilibrium point. Both of these approaches are essentially nondynamic. We add an explicit replicator dynamic from evolutionary game theory to provide for a sensitivity analysis that encompasses both models and contains the results of both depending on parameter settings.     

Audit opinion improvement and the timing of disclosure

Companies have been found to report positive information more quickly than they report negative information (i.e., good news early, bad news late). This paper investigates the potential impact of audit opinion change on the timeliness of financial disclosures, with improvements in audit opinion considered to be “good news.” We take both the direction and the magnitude of audit opinion change into consideration, with magnitude measuring how far the opinion is from an unqualified opinion (i.e., an unqualified opinion with explanatory paragraph is closer to an unqualified opinion than a qualified opinion is). We find that firms experiencing an improvement in their audit opinions disclose their financial results earlier, while those with audit opinion deteriorations report their financial results later, and that these effects were related to the magnitude of the opinion change. What's more, there is an asymmetric response to good audit opinion news vs. bad audit opinion news, with bad audit opinion news having a larger effect on earnings timeliness than the effect on earnings timeliness of good audit opinion news. Overall, our results support the “good news early, bad news late” notion. Finally, we also find that overall earnings timeliness has improved in China since the enactment of new reporting regulations in 2006.     

Financial contagion in the laboratory: The cross-market rebalancing channel

We present the results of the first experimental study of financial markets contagion. We develop a model of financial contagion amenable to be tested in the laboratory. In the model, contagion happens because of cross-market rebalancing, a channel for transmission of shocks across markets first studied by Kodres and Pritsker (2002). Theory predicts that, because of portfolio rebalancing, a negative shock in one market transmits itself to the others, as investors adjust their portfolio allocations. The theory is supported by the experimental results. The price observed in the laboratory is close to that predicted by theory, and strong contagion effects are observed. The results are robust across different market structures. Moreover, as theory predicts, lower asymmetric information in a (“developed”) financial market increases the contagion effects in (“emerging”) markets.     

The global financial crisis and the evolution of markets, institutions and regulation

This paper analyses the recent global financial crisis in the context of the dual processes of market development and regulation. It discusses how, in the absence of a globally integrated financial framework, past and present regulations and interventions in reaction to national and global financial crises did not resolve the cross border regulatory arbitrage. The paper discusses how crises often lead to the emergence of new national and international institutions. It also analyses the proposed “new global framework” that needs to be in place if the policy recommendations contained in the G20 communiqué are going to be effectively implemented. The paper argues that unless international agreements are ratified by all nations and become part of national rules and laws, the presence of regulatory arbitrage and the lack of adequate cross border information and data may prevent the global economy from addressing the underlying causes of the recent global financial crisis. The paper also discusses the evolution of central banks and their new role in contributing to global financial stability. The paper argues that the recent global financial crisis has provided a unique opportunity to go beyond economic data and attempt to capture cross border financial data and other information that could assist international and national institutions to measure and manage financial risk more effectively. Finally, the paper discusses “too big to fail” and argues that only an internationally integrated financial system will make large banks global, both when operational and in the event of insolvency.     

Firm age and the evolution of borrowing costs: Evidence from Japanese small firms

This paper investigates how firms’ borrowing costs evolve as they age. Using a new panel data set of about 100,000 bank-dependent small firms for 1997–2002 and focusing on the channel of “adaptation” (i.e., surviving firms’ borrowing costs decline as they age) and that of “selection” (i.e., total borrowing costs decline as defaulting firms exit), we find that the reputation hypothesis suggested by Diamond (1989) provides a more plausible explanation of the downward sloping age profile of borrowing costs than the firm dynamics (Cooley and Quadrini, 2001) or the relationship banking (Boot and Thakor, 1994) hypothesis. In addition, we examine whether the firm selection process in Japan has been natural or unnatural. Our findings suggest that it has been natural in that firms with lower quality are separated, face higher borrowing costs, and are eventually forced to exit, which contrasts with the results of previous studies on credit allocations in Japan, including Peek and Rosengren (2005). Further, we find that the evolution of borrowing costs is partially due to selection but is mainly attributable to adaptation.     

International lending of last resort and moral hazard: A model of IMF's catalytic finance

This paper analyzes the trade-off between official liquidity provision and debtor moral hazard in international financial crises. In the model, crises are caused by the interaction of bad fundamentals, self-fulfilling runs and policies by three classes of optimizing agents: international investors, the local government and an international official lender. Limited contingent liquidity support helps to prevent liquidity runs by raising the number of investors willing to lend to the country for any given fundamentals, i.e., it can have catalytic effects. The influence of the official lender is increasing in the size of its interventions and the precision of its information. Unlike the conventional view stressing debtor moral hazard, our model identifies circumstances in which official lending actually strengthens a government's incentive to implement desirable but costly policies.     

Banks, markets, and efficiency

A competitive financial system can help reduce banks’ monopoly power and the associated inefficiencies. However, according to Diamond (J Polit Econ 105: 928–956, 1997) and Fecht (J Eur Econ Assoc 6(2), 2004) competition with the financial sector may also constrain the amount of liquidity insurance that banks can provide to households affected by unobservable idiosyncratic liquidity shocks. To study this trade-off, we model competition between banks and between banks and financial markets. Our analysis shows that competition between banks and financial markets can constrain the risk-sharing offered by deposit contracts. This effect is the same if competition between banks mainly affects the reallocation of deposits. However, if banking competition primarily affects new deposits, then such competition only limits inefficient monopoly rents without restraining risk-sharing. We would like to thank Diemo Dietrich, Phil Dybvig, Hans Peter Grüner, Martin Hellwig, Elu von Thadden, Uwe Vollmer, Wolf Wagner as well as seminar participants at the Bundesbank, at the University of Mannheim, at the University of Tilburg, at the 3rd Workshop on Monetary and Financial Economics in Halle, at the University of Lausanne, at the First ProBanker Symposium in Maastricht, at the Global Finance Conference 2005 in Dublin, at the European Economic Association Meeting 2005 in Amsterdam, at the International Finance Conference 2005 in Copenhagen, and at the German Economic Association Meeting 2005 in Bonn. We thank Mike Demott for editorial assistance. The views expressed here are those of the authors and not necessarily those of the Deutsche Bundesbank, the Federal Reserve Bank of New York, or the Federal Reserve System.